Bad stocks and boom times

It's counterintuitive, but investors need to be most cautious when business conditions are booming.

In Common Stocks and Uncommon Profits, a book written amost 50 years ago, Phil Fisher made a point that resulted in an epiphany for this analyst when he read it some years ago. It’s a long quote, but worth repeating.

Fisher explained that an in-depth study revealed that ‘nearly all companies have broader profit margins—as well as greater total dollar profits—in years when an industry is unusually prosperous. However, it also becomes clear that the marginal companies—that is, those with the smaller profit margins—nearly always increase their profit margins by a considerably greater percentage in the good years than do the lower-cost companies... This usually causes the weaker companies to show a greater percentage increase in earnings in a year of abnormally good business than do the stronger companies in the same field. However, it should also be remembered that these earnings will decline correspondingly more rapidly when the business tide turns... For this reason I believe that the greatest long-range investment profits are never obtained by investing in marginal companies... Investors desiring maximum gains over the years had best stay away from low profit-margin or marginal companies.’

We’ve been banging on about overpriced stocks and unsustainable profit margins for a while, so now seems a good time to take a closer look at Fisher’s conviction. Why is it that less impressive companies provide the biggest boom-time gains?

Lotsa Profits meets Thin Ice

Let’s consider the example of two Australian widget makers, Lotsa Profits Pty Ltd and The Thin Ice Company. In year one, an ‘average’ year for widget demand, each company achieves sales of $100m. But profits are anything but equal, as Lotsa has been far superior in managing costs. It has negotiated a much better deal on factory rent, ensuring lower fixed expenses. And due to superior staff and better use of new manufacturing techniques, Lotsa also has lower variable expenses—equating to 40% of sales, compared to 45% for Thin Ice. In this normal environment, Lotsa recorded earnings before interest and tax (EBIT) of $20m—which amounts to a profit margin of 20%. Thin Ice only managed $5m, or 5%, for its efforts.

Now we move into year two and a very different environment. Booming Japanese demand means that both companies are able to sell 20% more widgets. Fixed expenses, as you might expect, are unchanged, while variable expenses rise slightly more for the less efficient Thin Ice than for Lotsa. In the end, Lotsa’s profit rises $12m to $32m, while Thin Ice’s grows $11m to $16m—amounting to a 60% increase for Lotsa, compared to 220% for Thin Ice. And while Lotsa’s profit margin has grown by 34% to 26.7%, Thin Ice has seen its margins expand by 166% to 13.3%.

Rising tide

With net profit and earnings per share growth rates for Thin Ice leading the industry this year, the business press is glowing about its reinvigorated strategy and resurgent results. Slavishly, the share price follows suit. But why do the numbers look comparatively better for Thin Ice? The boom conditions help the company to clear its normally prohibitive fixed expenses, going from marginally profitable to quite profitable with a moderate lift in sales.

While it’s commonly said that a rising tide lifts all boats, the fact is that a rise in sea level has a much greater impact on a boat that’s grounded on a sand bar, than on one that’s already sailing in open water.

Year three, though, sees a sharp downturn, as can happen in the widget game. Demand softens and sales for both businesses fall to $80m. As Fisher predicted, the earnings for the more marginal company, Thin Ice, ‘will decline correspondingly more rapidly when the business tide turns’. When compared with an ‘average’ year, Thin Ice’s margins have fallen 250% (into red ink territory) while Lotsa’s have only halved.

No wonder Phil Fisher avoided marginal companies like the plague. Although his investing style was very different, Ben Graham sang a similar tune when he said that ‘observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favourable business conditions. The purchasers view the current good earnings as equivalent to “earning power” and assume that prosperity is synonymous with safety.’

In light of all this, we’ll only consider the purchase of marginal businesses at gobsmackingly cheap prices—which rarely appear during boom times. While we've made good money purchasing stocks like Grand Hotel Group and FKP in times of unfavourable business conditions and dirt cheap stock prices, expect us to steer clear of poor-quality businesses when conditions are buoyant. The upside is restricted and the risks are too great.

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